Contestability and collateral in credit markets with adverse selection

The work discusses a basic proposition in the theory of competition in markets with adverse selection (Bester, 1985). By working out the sequence of market transactions, we show that the effectiveness of collateral in avoiding equilibrium rationing depends on an assumption of uncontestability of the loan market. If contestability is restored to its proper place, the separation of borrower by means of sufficient collateral does not impede the emergence of credit rationing, which results from a coordination failure among risk-neutral banks. As a consequence, even in a risk-neutral environment with suitable endowments, the use of collateral in credit contracts could not be a socially efficient screening-device. Our conclusion on rationing does not stand in contrast with the general result of Gale (1996).